Will Brazilian equities hold up amid rising risk aversion?

Commodities and emerging middle-class consumers fuel economic growth

By

PolyaLesova

NEW YORK (MarketWatch) -- Can the Brazilian stock market, one of the star performers of the last two years, stand its ground in the face of a sharp spike in global risk aversion?

Tracking a late rebound on Wall Street, Brazilian stocks finished higher Wednesday, after being rattled along with international markets by fear that U.S. credit and housing problems are spilling over globally. See full story.

Those same fears led the Bovespa stock index to tumble 7.9% last week in Sao Paulo.

But analysts say it is external factors that have triggered the recent correction, not Brazilian fundamentals, which remain robust. In May, Fitch Ratings and Standard & Poor's raised Brazil's foreign currency rating, elevating it to just one notch below investment grade.

Lured by economic growth, strong corporate earnings and political stability in South America's largest country, investors have been gobbling up Brazilian stocks, propelling the benchmark index to record highs more than 30 times this year.

The Bovespa index has surged 22% year-to-date, outperforming many other emerging-market benchmarks, including those in fellow BRIC countries Russia and India. With a 34% return, Brazil was also one of the top-performing markets of 2006 measured in dollar terms.

"The fundamentals of the country are strong and internal consumption will continue to grow and therefore to trigger good results for most companies," said Ignacio Goni, Buenos Aires-based head of research for Latin America at the Riedel Research Group.

"That said, investors had had a very good run in the past years with their investments in Brazil, therefore I wouldn't be surprised to see many of them pulling out of that market after any bad news on the global economy growth, particularly the US economy, in order to secure the profits already achieved," Goni said.

Thanks to strong demand from China, India and other fast-growing economies, commodity prices have surged, a bonanza for Brazil, which produces numerous soft and hard commodities, including iron ore, soybeans and coffee.

Current credit concerns, however, raise the risks that U.S. and global growth might slow down, or worse, grind to a halt. On Wednesday, the International Monetary Fund said that the vulnerabilities of both U.S. financial markets and underlying economic activity were clouded by the growth of derivatives in credit markets. See full story.

Brazilian consumers to the rescue?

But barring global disaster scenarios, analysts believe that the changing fundamentals of some emerging markets, such as Brazil, make them less vulnerable than in the past to external crises.

UBS analysts said Wednesday that global emerging markets valuations and earnings momentum remain attractive and the current weakness is a buying opportunity. Brazil and Taiwan are UBS's top picks.

"Despite strong performance in recent months, both remain among the most attractively valued in global emerging markets," said Oussama Himani, strategist at UBS, in a research report.

Analysts also point to the increasing economic importance of the Brazilian middle class.

"You have this emerging class of consumers that is really going to drive the economy," said Terrence Gray, portfolio manager for the DWS Emerging Markets Equity Fund
SEMGX, +0.17%
at DWS Scudder.

"They'll be able to buy their first home, their first car, and their first credit card," Gray said. "These products we take for granted, but in Brazil that creates a base of the economy that hasn't been explored before. We've been looking at how to play the consumer in Brazil rather than just playing iron ore."

Suring portfolio inflows

Brazil equity funds tracked by EPFR Global took in another $75.3 million in the week ending July 25, bringing year-to-date inflows to $1.58 billion, or 39% of their total assets at the beginning of the year.

A proxy group of about 1,000 equity funds with $900 billion in assets were net buyers of Brazil equities for the third straight month in June when they bought a net $899 million, bringing the total to $2.4 billion in the last three months, according to EPFR Global.

Global emerging markets equity funds increased their weightings to Brazil to 9.01% by the end of June, up from 8.5% the previous month, according to EPFR Global. Brazil remains the biggest country overweight of GEM funds against the benchmark MSCI Emerging Markets Index.

Besides the good returns, investors have been attracted by expectations of 4.5% GDP growth this year, strong corporate earnings and relatively cheap valuations, said Brad Durham, managing director of EPFR Global.

"Brazilian yields and also equities look relatively cheap compared to other markets," said Nick Chamie, chief emerging markets strategist at RBC Capital Markets. "Growth prospects have been improving for both FDI and equities."

"Lula has continued to follow a stable, market-friendly economic policy and that's helped to embolden increased levels of foreign investment," Chamie said.

Stable politics, soaring currency, falling rates

President Luiz Inacio Lula da Silva, known as Lula, won a second term last year in a landslide victory. Lula of the left-wing Workers' Party has vowed to stimulate economic growth and narrow staggering income inequalities between rich and poor Brazilians.

Despite Brazil's economic advances, the poorest one-fifth of its 182 million people account for only a 2.4% share of the national income, making Brazil second only to South Africa in a world ranking of income inequality, according to the World Bank.

The country also confronts infrastructure challenges. A deadly plane crash earlier this month highlighted broader criticisms of the Brazilian government that air-related infrastructure has not kept up with the quick pace of growth. See Due Diligence.

Most observers agree, however, that Lula has implemented prudent fiscal policies, stabilizing the economy and bringing down inflation and debt.

"Surprisingly, Lula has maintained a primary fiscal surplus," said Don Elefson, portfolio manager of Excelsior Emerging Markets Fund
UMEMX, +0.28%
"He does have a very broad popular following, but he's proven himself to be a friend of business too."

Brazil has been running sizeable trade and current account surpluses. These surpluses coupled with very strong capital inflows into Brazil have pushed the real to appreciate about 11% against the dollar this year.

Brazil's current account surplus was $15.2 billion, or 1.3% of GDP, as of June. Foreign direct investment in Brazil has climbed to $32.3 billion over the last 12 months, reaching over $10 billion in June alone. Net foreign portfolio inflows have risen above $24 billion in the first half of this year.

Interest rates in Brazil have been going down steadily over the last two years, prompted by moderate inflation and accelerating economic growth. Annual inflation reached 3.7% by the end of June, below the central bank's annual target of 4.5%. On July 18, Brazil's central bank reduced its benchmark interest rate by 0.5% to 11.5%, making its 17th consecutive rate cut. Rates have dropped by 825 basis points from their peak of 19.75% in August 2005.

Brazil's stock rally has been fuelled in part by bond investors switching from bonds into stocks, amid falling interest rates, in pursuit of better returns, Elefson said.

Goni of the Riedel Research Group agreed: "Investors in bond markets in Brazil have actually made huge profits from bonds." When rates were around 19%, bond investors made profits of over 60%, he said. As rates declined, however, investors have turned to stocks.

"Bond investors fell in love with the Brazilian market and now they're thinking they know it well enough to make more volatile investments which would be stocks," Goni said. "It'll give them increased volatility, but also more exposure to profit."

Among the main reasons for this year's rally in Brazilian stocks is the appreciation of the most highly traded shares, such as Petrobras and CVRD, as well as the very sizeable strengthening of the real, Goni said.

The market capitalization of Bovespa's listed companies amounted to $1 trillion in June. The net inflow of foreign investments in the Brazilian stock market totaled $7.5 billion as of June 30. There have been nearly 30 initial public offerings on the Bovespa so far this year.

International investor participation in public offerings represented 73.4% of the total value of offerings in 2007, which amounted to about $10.4 billion year-to-date.

Attractive sectors

"There's definitely, given the capital market activity, a lot more variety of investable stocks in terms of industries," said David Semple, portfolio manager of the Van Eck Emerging Markets Fund
GBFAX, +0.50%
Two years ago, for example, there were no real estate stocks of any consequence, whereas today a number of real estate companies are listed. Liquidity has also improved, Semple said.

"We're still very keen on the iron ore sector, which is principally CVRD," Semple said. He also likes some real estate companies, such as BRMALLS, the largest integrated shopping center company in Brazil with a portfolio of 26 malls. Semple also likes retail plays such as Localiza, the largest car rental business in Latin America, and education provider Anhanguera.

"I see Brazil performing in line with other EM [during the rest of the year]," Semple said. "One thing to watch is food inflation, soft commodities inflation. Brazil is in a very sweet spot as far as that's concerned. It's one of the largest producers of a lot of soft commodities."

"The long-term story is intact," Gray said. "Near term, the market had a very strong run and is due for a bit of a pause. We don't expect any crises in Brazil - economic or political. This country is moving toward investment grade."

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